Bank of England embarks on quantitative easing

WilliamL. Watts

LONDON (MarketWatch) -- The Bank of England took unprecedented steps Thursday to prevent a deflationary spiral, launching a program to effectively print money through the purchase of billions of pounds worth of corporate and government bonds.

The nine-member Monetary Policy Committee also voted to cut the bank rate from 1% to 0.5%, the lowest level in the central bank's 315-year history.

The rate cut, which had been widely anticipated, could be the final reduction in a series of cuts that have seen the key lending rate slashed from 5% since October.

In a statement, the policy-setting MPC said the bank would buy a total of 75 billion pounds in high-quality corporate debt and U.K. government bonds, or gilts, over the next three months. The majority of purchases will be medium- to long-maturity gilts, the Bank of England said. Read the statement.

The move makes the Bank of England the first European central bank to join the U.S. Federal Reserve and the Bank of Japan in a rare practice known as quantitative easing. The long-expected decision came after the MPC determined that a rate cut alone wouldn't be enough to prevent inflation from significantly undershooting the central bank's 2% annual target.

'It's a dramatic announcement, and all else being equal, you have to think that until there are signs of some traction getting back into the economy ... it's extremely bullish for gilts.'
John Wraith, RBC Capital Markets

"Accordingly, the committee also resolved to undertake further monetary actions, with the aim of boosting the supply of money and credit and thus raising the rate of growth of nominal spending to a level consistent with meeting the inflation target in the medium term," the statement said.

The purchases will be paid for by the creation of new central bank reserves.

In other words, the Bank of England will purchase the assets from financial institutions and credit their reserve balances at the central bank, electronically creating new money.

The central bank is aiming to boost the money supply in hopes the moves will ease tight credit conditions and translate into increased spending, thereby preventing a sustained, widespread and potentially destructive fall in prices.

Also, purchases of high-quality corporate debt and gilts will bring down interest rates.

The U.K. Treasury has authorized the central bank to expand the plan to150 billion pounds, if needed, pushing the total size of the initiative toward the top end of expectations. Also, the three-month window for the operation is also aggressive, said John Wraith, a gilt strategist at RBC Capital Markets.

The news sent gilt prices soaring, particularly at the long end. Yields, which move inversely to price, fell sharply.

The 10-year bond's yield dropped 34 basis points, or 0.34 of a percentage point, to around 3.29%, according to FactSet Research.

"It's a dramatic announcement, and all else being equal, you have to think that until there are signs of some traction getting back into the economy ... it's extremely bullish for gilts," Wraith said.

In foreign-exchange dealings, the pound initially spiked on the news, then tumbled. Sterling recently changed hands at $1.4117, a loss of 0.5%. See Currencies.

Not done yet

With the Bank of England now focused on boosting the money supply, it's likely that the pound will be exposed to further selling pressure, said Kenneth Broux, economist at Lloyds TSB.

Meanwhile, the effect of quantitative easing on nominal spending isn't likely to materialize in the near future, he said, noting that British consumers remain highly leveraged and that corporate default rates are on the rise.

Indeed, a rise in bank lending and broad money growth might not bring about a big rise in economic activity if firms don't spend the extra money, said Jonathan Loynes, chief European economist at Capital Economics.

In technical terms, the rise in the money supply could be offset by a slowdown in the "velocity of circulation" of money, he said.

"The upshot is that we suspect that the MPC will have to use the full 150 billion pounds, or even more, if it is to have a material impact on the economy and inflation," Loynes said.

British gross domestic product shrank at a quarterly rate of 1.5% in the final three months of 2008, the sharpest contraction since the early 1980s.

The International Monetary Fund has forecast the British economy would post the worst performance in the developed world for 2009, projecting a 2.8% drop in GDP.

Surveys measuring confidence in the manufacturing and services sectors point to ongoing retrenchment in activity, although the pace of contraction appears to have slowed in recent months.

Meanwhile, house prices continue to plunge following the bursting of a housing bubble in 2007.

Mortgage lender Halifax, a unit of Lloyds Banking Group, reported Thursday that house prices fell 2.3% in February, wiping out a 2% January bounce. The three-month average house price was 17.7% below the level seen in February 2008.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.